Compensating balance is a balance that must be held with a lender in order for a borrower to be eligible for an installment loan or line of credit. Show
Let’s take a closer look at what a compensating balance is and how it works, so you can understand how it may apply to your situation. The balance you agree to maintain with a lender as a borrower is known as a compensating balance. It’s intended to reduce the cost of lending for the lender because it allows them to invest the cash in the compensating balance account and keep all or a portion of the proceeds. A compensating balance may also benefit you as a borrower because you’ll likely be able to secure a lower interest rate. Let’s say you’re a small business owner. You want to borrow a $50,000 line of credit. ABC Bank offers you a $70,000 line of credit with a $10,000 compensating balance. In this situation, you’ll be on the hook for that $10,000 each month, whether you access the line of credit or not. If you do withdraw funds from the line of credit, you’ll be responsible for the interest on what you borrow plus the $10,000 compensating balance.
A compensating balance acts as collateral for the lender, allowing them to take on less risk when lending money. Often, you’re forced to accept a compensating balance as a borrower. Maybe you’re a new small business and don’t have a credit history, so this is your only option. Perhaps an offer with a compensating balance provides you with an overall better deal. A compensated balance is usually kept in a deposit account, such as a checking or savings account or a certificate of deposit (CD). It can be calculated in two ways: as an average balance arrangement or a minimum fixed balance arrangement. While the average balance is common with installment loans, the minimum fixed balance is widely seen with lines of credit. If your agreement has an average balance agreement, you must maintain a minimum average balance over an agreed-upon term, which is typically 30 days. With a minimum fixed balance, you’ll be required to always keep an agreed minimum balance with the lender. It’s not uncommon for borrowers to commit to a compensating balance without knowing it. Before you take out a loan, be sure to read the fine print and find out whether you’ll be responsible for a compensating balance.
Also, when you take out a loan with a compensating balance, you must report the balance as “restricted cash” in your financial statements. Restricted cash refers to money that is reserved for a specific purpose and not available for general or immediate business use.
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A compensating balance is a minimum deposit that must be maintained in a bank account by a borrower. … The borrower cannot use the money but is required to disclose it in the borrower’s notes attached to its financial statements. Example of a Compensating Balance A corporation has a $5 million line of credit with a bank. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250 000. When the two sides of the arrangement are netted the loan is actually $4 750 000. What is compensating balance quizlet?A compensating balance is a minimum balance that must be maintained in a bank account and the compensating balance is used to offset the cost incurred by a bank to set up a business loan. … The bank is free to loan the compensating balance to other borrowers and profit from differences between the interest rates. How are compensating balances reported in financial statements?A compensating balance can be defined as the balance which the borrower of the money has to keep in its bank account as security. They are part of the corporate loans. … The compensating balance cannot be used by the firm so it is shown as the restricted cash in the financial statements. However if it is anticipated that the cash will remain unavailable for use for more than a year then it should be classified as a non-current asset. A compensating balance is a minimum balance that a company must maintain in an account as part of an agreement with a current or potential lender. What is the primary purpose of compensating balance?Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. The primary objective of such a balance is to reduce the lending cost of a borrower. How do you find compensating balance?Divide the nominal interest due by the available principal to calculate the effective interest rate of your compensatory balance installment loan. Example: Assume the interest rate on a compensatory balance loan has an interest rate of 5 percent a principal of $100 000 and a compensatory balance of $5 000. What is a compensating balance chegg?Compensating balances is defined as the minimum amount which the borrower keeps with the bank. … The corporate borrower discloses the compensating balance amount as separate line item in the financial statements if the amount is material else it is disclosed with cash balance (restricted cash). Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest. The compensating balance offsets the bank’s default risk and can be used to make new loans. The business borrower must report the compensating balance in its financial statements typically as restricted cash. What is the allowance for uncollectible accounts?Allowance for uncollectible accounts is a contra asset account on the balance sheet representing accounts receivable the company does not expect to collect. When customers buy products on credit and then don’t pay their bills the selling company must write-off the unpaid bill as uncollectible. What is line of credit for compensating balance?A compensating balance is a percent of the value of the bank line that must be maintained as a deposit at the bank. For example if the line of credit goes up to $100 000 and the compensating balance is 10% then the borrower must maintain a deposit at the bank of at least $10 000. What effect does a compensating balance requirement have on the effective interest rate on a loan?Compensating balances also decrease the proceeds of the loan. As proceeds decline the effective interest rate rises. Example: You borrow $ 30 000 at 12%. The Bank requires that you maintain a 10% compensating balance. As the amount of compensating balance for a given loan size increases the effective return on the loan increases for the lending institution. What is the accounting for goodwill?Goodwill is calculated by taking the purchase price of a company and subtracting the difference between the fair market value of the assets and liabilities. Companies are required to review the value of goodwill on their financial statements at least once a year and record any impairments. Is Restricted cash?
Restricted cash refers to money that is held for a specific purpose and thus not available to the company for immediate or general business use. … Cash can be restricted for a number of reasons including debt reduction and capital investments.
See also where did the term cottage industry get its name What is a revolving credit agreement?Revolving credit is an agreement that permits an account holder to borrow money repeatedly up to a set dollar limit while repaying a portion of the current balance due in regular payments. What will be the shortage cost associated with a compensating balance requirement?What will be the shortage cost associated with a compensating balance requirement? It will depend upon the terms of the associated loan but will usually involve some sort of penalty for failing to maintain the balance. What is the goal of credit policy?The end goal of all credit policies is to maximize the company revenue/business while minimizing the risk generated by extending credit. Who runs Libor?
the Intercontinental Exchange
LIBOR is administered by the Intercontinental Exchange which asks major global banks how much they would charge other banks for short-term loans. Is prime rate a floating rate?Two of the most common reference rates used with floating interest loans are the prime rate in the U.S. and in Europe the London Interbank Offered Rate (LIBOR). The floating rate will be equal to the base rate plus a spread or margin. A collection float refers to the number of shares an issuing entity has not repurchased and that are available for trade by the general public. Sometimes it is simply known as a float. 2. A deposit into a bank account that has not yet cleared. For example one may deposit a check for $1 000 from an out-of-state bank. Is allowance for bad debts an expense?Allowance for doubtful accounts on the balance sheet
See also what is a material resource When you create an allowance for doubtful accounts you must record the amount on your business balance sheet. If the doubtful debt turns into a bad debt record it as an expense on your income statement. It is necessary to write off a bad debt when the related customer invoice is considered to be uncollectible. Otherwise a business will carry an inordinately high accounts receivable balance that overstates the amount of outstanding customer invoices that will eventually be converted into cash. What is the bad debt expense account?
A bad debt expense is a portion of accounts receivable that your business assumes you won’t ever collect. Also called doubtful debts bad debt expenses are recorded as a negative transaction on your business’s financial statements. Every business has its own process for classifying outstanding accounts as bad debts. What does it mean to roll over debt?A rollover is the renewal of a loan. Instead of liquidating a loan on maturity you can roll it over into a new loan. The outstanding principal and other components of the old loan are rolled-over with or without the interest outstanding on it. How do you calculate effective interest rate on installment loans?
Here’s the calculation:
The effective interest rate is calculated through a simple formula: r = (1 + i/n)^n – 1. In this formula r represents the effective interest rate i represents the stated interest rate and n represents the number of compounding periods per year.
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Cash and cash equivalents refers to the line item on the balance sheet that reports the value of a company’s assets that are cash or can be converted into cash immediately. Cash equivalents include bank accounts and marketable securities such as commercial paper and short-term government bonds. What is commercial prime lending rate?The prime rate (prime) is the interest rate that commercial banks charge their most creditworthy customers generally large corporations. The prime interest rate or prime lending rate is largely determined by the federal funds rate which is the overnight rate that banks use to lend to one another. What type of credit is trade credit?What Type of Credit Is Trade Credit? Trade credit is commercial financing whereby a business is able to buy goods without having to pay till later. Commercial financing in relation to a trade credit comes at a 0% borrowing cost. The double entry for this is therefore to debit the full market value to goodwill credit the share capital figure in the consolidated statement of financial position with the nominal amount and to take the excess to share premium/other components of equity also in the consolidated statement of financial position. What is the journal entry for goodwill?The goodwill account is debited with the proportionate amount and credited only to the retired/deceased partner’s capital account. Thereafter in the gaining ratio the remaining partner’s capital accounts are debited and the goodwill account is credited to write it off. What happens to existing goodwill in an acquisition?Any goodwill or deferred tax items existing on the target’s balance sheet at the time of acquisition are written off in the purchase price allocation (PPA) since their fair values (FVs) are zero. Are stamps considered cash?Cash equivalents can also include government and corporate bonds marketable securities and commercial paper. … Other investments and securities that are not cash equivalents include postage stamps IOUs and notes receivable because these are not readily converted to cash. What is a Compensating BalanceCompensating balanceCost of Bank Loan: Simple Interest with Compensating Balance |
Compensating balances are a cost to the borrower and generate income to the lender
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